Solving the franchise financing puzzle

Most franchisees use a mixture of borrowing and cash reserves when investing in a business. But what is the best funding formula?

You have found a great franchise opportunity and the time is right to become your own boss. But then comes the issue of raising the money. Franchisees are expected to put a decent amount of personal funds into an operation but many need to top up with some borrowing. How much debt can – and should – would-be business owners take on? What do franchisors want to see in terms of the financial commitment of the individual running an outlet? Fundamentally, is there such a thing as a perfect funding balance?

Finding personal funds

While the latest research from the bfa showed greater numbers of people under the age of 30 going into franchising, the majority of newer franchisees are still in their 40s and have some decent experience of the working world. It’s not just greater wisdom that prompts those in mid-life to think about investing in a franchise; many will have built up a nest egg that they’re ready to use to change the way they work and earn a living. Others decide to pool savings from family or friends – although agreeing terms in writing or treating contributors as investors is advisable even in close relationships. In recent years, a good proportion of those who have entered the franchising arena will have done so using a redundancy pay-off – a common trend in tougher economic times.

Wherever the money comes from, significant personal investment in a franchise is both a reality and a requirement. Franchisors want to see evidence that an individual is serious about making a go of the business and the more of their own cash they put up at the outset, the better impression they give that they’re determined to succeed. Equally, if someone needs to borrow to fund part of the franchise, banks and other providers are often reassured to see a franchisee who has really committed themselves financially.

But how much is enough? A minimum investment of 30% of the total cost of the franchise from personal resources is typically expected; certainly from established franchisees. Absolute beginners may be required to put in more, possibly as much as 50%. Even if you have built up a healthy investment pot, it’s generally accepted that no one should put absolutely all of their savings into a business. A commonly held rule of thumb is that it’s wise only to invest a maximum of 75% of total cash reserves. This allows for a financial cushion should unexpected business costs materialise further down the line. Also, you need to be realistic about what you can afford to spare from personal coffers once you’ve taken all your liabilities – mortgage, household bills, and personal expenditure – into account.

Once you know the investment total, how much you can commit and how much of a shortfall there is, it’s time to think about borrowing.

Overcoming fear of debt

Borrowing to finance a franchise is commonplace – three out of five franchisees need to borrow to fund their enterprise, according to the bfa. Yet, some would-be entrepreneurs remain wary of debt and retain an old-fashioned fear of being in hock, even temporarily. Insufficient capital is the number one reason that franchisors turn down franchise applicants and bfa research has consistently found that lack of finance ranks as the greatest barrier to franchise unit growth in the UK. The message is clear: sometimes debt is necessary for business growth.

When handled sensibly, borrowing can be beneficial and, without it, fewer enterprises would exist, let alone grow. Those who are determined to take on and run a successful franchise will almost certainly need to borrow at some point. Therefore, it is wise to come to terms with the idea of debt and make understanding the various options available a priority.

One of the merits of using borrowed money to finance an enterprise is that business owners can retain some personal funds as backup should a pressing need arise in the future – not an uncommon occurrence in a newly established enterprise. And don’t forget that debt no longer necessarily means a loan from the bank. There are many available forms of flexible financing that can be suitable in different situations. For example, leasing rather than purchasing equipment could conserve capital when a franchise is finding its feet. Such a move could both improve the company’s liquidity and, again, create a rainy day fund. Taking out a short-term loan to cover a bulk purchase of stock could be useful for a business that has little ready cash immediately but knows trade will pick up and doesn’t want a debt hanging over its head for years to come.

Whatever the scenario, there is an abundance of funding available to franchisees these days, from invoice and asset finance to the new generation of alternative funders. Your franchisor may also have existing relationships with banks or specialist franchise funders but it’s best to research all possibilities to determine what arrangement – or mixture of debt options – may best suit your operation.

Running the numbers

When considering taking on any borrowing, it’s essential to weigh up the cost of regular debt repayments against earnings forecasts for the franchise. Newly established businesses often lack working capital as they wait to turn a profit, so consider this in any calculations. It’s also worth remembering that debt is typically paid from cash flow, so be confident the business isn’t taking on too much and will be able to cope in the short-term.

Put simply, the right-sized loan is the one you can afford to repay. Again, a smart franchisee will be able to estimate future trading profits – after taking all financial commitments into account – and will have a realistic idea of the level of sales needed both to break even and to reach a point where profit is achievable. A responsible franchisor should offer a detailed breakdown of the costs involved in getting the franchise up and running, as well as help with preparing cash flow forecasts.

In essence, there is no magic formula to get the right balance of debt and direct investment in a business – each case will be different. But those who dream of running their own franchise should expect to part with a sizeable sum of personal savings and get themselves used to the idea of borrowing in order to turn their fantasy of business success into reality. Debt in itself is not a bad thing; far from it. When handled intelligently and responsibly, it can be the key to longer-term prosperity. But calculate your franchise’s projected figures and know them inside out, always research any opportunity thoroughly and ask difficult questions of the franchisor before committing.

If you decide franchising is for you, with the right balance of funding, the sky really could be the limit.

About the Author

Littner certainly has pedigree when it comes to finance. Currently managing director at Boost Capital, a business funding company, he previously spent eight years at American Express working on its Small Business Card Portfolio across EMEA, Asia-Pacific, Latin America and the Caribbean. Away from work, Littner is a family and football man: he has a two-year-old daughter and an Arsenal season ticket.